PEG Worries
Has the US Dollar outlived its usefulness for the GCC economies? Will the fast-growing economies of the region do better if their currencies are decoupled from the Dollar? These and other aspects are explored in this special cover story by Ramesh Kumar

Christine DeCosta, on her return to Muscat a few months ago after her annual vacations to India, got the shock of her life when her landlord ‘asked’ for’ an abnormal hike in the rent for her two-bed room apartment at Al-Khuwair. The attitude was: take it or leave it. She consented without a protest.

The Managing Director of a leading financial services company had to involuntarily give a 10 per cent hike to his employees across the board ‘to retain the best talent’, who were hit by a double whammy: rising costs of living coupled with an erosion in the exchange rate. MD had no option either.

Companies that were offering two-bed room accommodation as a perk have been forced to scale down their offers to ‘single bedroom’ house. They had no other choice.

Queues inside money exchanges have not dwindled, instead are on the rise, thanks to the fall in the exchange value of Omani Rial against non-US Dollar currencies. Expats are in a no-hold mode – fearing a drop in the exchange rate on a daily basis – and pushing more money back home.

Welcome to the Sultanate of Oman. The US$35.3-billion economy growing at around 6.5 per cent per annum is a fact to cheer about. Global oil prices, soaring towards US$100 a barrel, are another reason to rejoice, notwithstanding the depleting reserves. Construction is in full swing. Multibillion-dollar tourism and infrastructure projects are being unveiled; in fact some are already underway. Yet, celebrations are missing. Not only in the Sultanate, but across the Gulf Cooperation Council member countries. The reason is not too far to seek: the US Dollar meltdown.

What has the Dollar’s debacle got to do with the Gulf currencies – be it the Omani Rial or Saudi Riyal, Qatari Rial, Bahraini Dinar, Kuwaiti Dinar, UAE Dirham? A lot, because the GCC countries are married to the US legal tender: officially, these currencies are ‘pegged’ to the US Dollar. And, this is why they are in a bind. If Dollar sneezes, the Gulf currencies catch a cold. If the Dollar falls, the Gulf currencies follow suit. And, vice-versa. So, is the marriage going bad. No, the difference today is that they got into this convenience of currency wedlock when the US currency was at its strongest. Today, the scenario is different.

Bleeding Dollar
The dollar is bleeding, thanks to a slew of factors: imports are on the rise, creating a huge current account deficit; the sub-prime lending crisis is giving the US Federal Reserve sleepless nights; even as expenditure is burgeoning on the ‘War on Terror’ front. Today, everyone expects Fed Chairman Ben Bernanke not to throw out the baby with the bathwater: to manage the domestic economy and simultaneously ensure the world does not go into a tailspin. After all, the world’s only superpower can ill-afford to be seen as the weakest.

When in September, Bernanke announced an unexpected 50 basis point cut in the US interest rates, as per conventional wisdom, the six-pack GCC member-countries should have followed suit, and eased their respective lending rates. But that is not what happened? The Kingdom of Saudi Arabia, the most powerful GCC giant and the world’s largest oil exporter, refused to tango, sending shock waves across the global currency markets. Reason: domestic compulsions. What is that? Read rising inflation on the home front. The Kingdom of Bahrain also said ‘No’, citing the same grounds. Of course, the Sultanate of Oman too joined cause with the Saudis on this issue.

What has inflation got to do with interest rates? When an economy is receding into recession, central banks invariably slash their interest rates to pep up lending, to boost demand and thus revive the economy. The American economy is in a poor shape and hence the Bernanke formula of slashing interest rate makes sense. But what about the booming oil-exporting Gulf economies? Should they swallow the same American recipe? Any sane economist will veto such a move. Why? A booming economy means heightened activity. Monetary policy initiatives such as reining in money supply is of paramount importance. To put it differently, tighten money supply via making lending costlier. That is, hike interest rates!

GCC Logjam
This is the logjam the GCC countries are in. They simply cannot ape the American monetary policy. A peek at the Gulf domestic inflation rates can be an eye-opener: Oman reported 6.47 per cent – the highest in 16 years as on August 31.

Saudi Arabia 4.4 per cent (August), a 7-year high; Bahrain 5.2 per cent (August); Qatar 12.8 per cent (June), UAE 9.6 per cent (2007), and Kuwait 5.5 per cent (March).

A single common thread, attributed to the rise in cost of living (that is what inflation is all about), was the abnormal increase in house rent and charges on food and beverages. Qatar’s finance minister Yussef Hussein Kamal, who was witness to 14.8 per cent inflation in March , claims that house rent has gone through the roof by a whopping 168 per cent in the past two years. The fact that 60-70 per cent of one’s personal income goes towards house rent in an economy growing at 8.8 per cent is a pain. Saudi Arabian Monetary Agency (SAMA) governor Hamad Saud Al-Sayyari admits that the price of essential commodities have risen by 6.6 per cent in addition to 12.1 per cent increase in rental outgo.

What about Oman? As per Central Bank chief Hamood Sangour Al Zadjali, the consumer price index rose to 111.9 points (August 31). According to him, the food and beverages and tobacco component surged 12.1 per cent and that of rent by 7.5 per cent. All these mathematical mumbo-jumbo will make sense when one realises that the rate of inflation in the entire Gulf stood at less than 1 per cent until two years ago. An almost frozen cost of living coupled with a tax-free regime was the major attraction for expatriates, on whom the richest Gulf region depends majorly for economic activities, to flock to this region for decades. Today, inflation is a reality resulting in an erosion in real income, upsetting all calculations.

Even the International Monetary Fund (IMF) does not mince words. It said in its biannual global survey released in mid-October that with booming demand and rising import prices, “inflation is accelerating” in the Gulf region. Consumer prices on an annual basis have shot up 10.8 per cent this year, after a 7.5 per cent increase in 2006, and are projected to rise 9.2 per cent in 2008. Any specific culprit? In the GCC, a weakening dollar has also added to inflationary pressures, raising the cost of imports, according to the IMF.

Kuwaiti Boldness
The Dollar meltdown is a major cause for concern for Gulf economies. Yet, they are not ready for quick, remedial action. There is a universal opinion that these countries ought to consider unplugging their Dollar parity. Bluntly put, move away from the apron strings of the US economy and prepare your own monetary policy. Kuwait is the solitary country in the region to have pulled out of the Dollar mystique. It did so in May, citing, what else, the Dollar’s slide in the global markets was making imports more expensive and driving up inflation. Instead, Kuwaiti Dinar will now be valued against a basket of currencies? Why? “It gives the bank the flexibility to track moves on global foreign exchange markets,” reasoned Central Bank governor Salem Abdul-Aziz.

Oman Scenario
What about other GCC members? Are they ready and willing to consider dropping Dollar parity? No way. Oman’s Commerce and Industry Minister Maqbool bin Ali Sultan admitted that Oman did consider measures, including unshackling the Rial from the tumbling US Dollar, but decided against the move. The options before His Majesty’s government are:

• Fixing of price for essential commodities

• Setting up of co-operative consumer societies

• Ending the Omani’s Rial peg with the US Dollar

• Government interference by providing commodities

• Monitoring prices

• Expanding foodstuff processing units

So far, Sultan has decided to stay with the Dollar “in view of the government’s strategy, which is based on free trade and market economics”. He went further to extol the virtues of such a linkage: “For an open economy like Oman, the fixed peg to the US Dollar works as the strongest source of stability, which is very essential for promoting trade and investment.”

Zadjali, while admitting that inflation is a matter of concern, does not want to panic. “The levels are still considered to be moderate when seen in relation to the high growth being witnessed in the economy and when compared within the region”. Inflation, according to him, is mainly from external sources, such as that arising from specific goods imported into Oman and the price pass-through effect of sustained depreciation of the US Dollar.

So, how does Oman plans inflation management? As against revaluing its currency, Oman in July dropped a provision allowing banks to use their foreign currency holdings as part of their 3 per cent reserve requirement. Besides, proper monetary management of liquidity and moderate fiscal expenditure will help rein in inflationary trends, Zadjali believes. To fight the rising rental outgo, the government has fixed a 15 per cent cap in hike for the next two years.

Middle East policymakers, IMF cautions, need to “carefully calibrate” their spending on investment and social projects to the capacity of the economy to absorb such outlays. But with the outlook for oil prices likely to remain strong, “raising the trend of government spending would be warranted.” As it has frequently done in the past, the IMF said the main challenge confronting oil exporters is to develop their non-oil sectors, an initiative that “hinges on reforms to improve the business climate and make investment in non-oil sectors more attractive.”

Varied Opinions
The Gulf economies’ fixation with Dollar parity has not been well received. Saxo Bank, in its recent report, says that from the Middle East perspective, the GCC could unanimously either re-peg their currencies to a lower dollar rate or they could instead peg it to a basket of currencies, including the Dollar. Such a scenario makes economic sense where the US economy is no longer the bedrock of the global financial system and trade flows from the Middle East are more dynamic and more multilateral, involving many economic partners.

To cut the Dollar link or not? Oman Chamber of Commerce and Industry Chairman Khalil Al Khonji is a Dollar sympathiser. “There are basically two schools of thoughts on this issue. I believe that from the perspective of industrialists and businessmen, staying with the dollar is a less risky affair than moving away to a basket of currencies.” Fincorp’ s Munir Makki prefers a moderate route. “Keep intact the Dollar but appreciate with it – which I think is the best way” (See Box: Appreciate Rial).

Unlike in the past, the Gulf economies do not entirely depend on its oil export to the US alone. Today, their trade partners are diversified and there is a concerted effort to move away from oil-dependency through various other non-oil export activities such as manufacturing, construction boom, free trade zones, etc. With China and India setting up a scorching growth path, their energy requirements are skyrocketing, thus creating a fresh business opportunity for the oil-rich Gulf economies.

Dollar Exit
Significantly, the Dollar meltdown has compelled many to take a fresh guard to protect their respective economies. Qatar, one of the staunchest allies of the US and whose currency is pegged to the greenback, is cutting down its Dollar exposure by half. Prime Minister and Foreign Minister Sheikh Hamad bin Jassim bin Jabor al-Thani revealed that in early October Qatar’s US$50 billion sovereign wealth fund brought its dollar exposure to 40 per cent. Qatar Investment Authority’s moolah is parked: 40 per cent in US Dollars; 40 per cent in Euro; and 20 per cent in other currencies. Does this mean, Qatar is readying for a delink from the Dollar? “Nothing at this moment. No,” adds Al-Thani.

Among other nations, Vietnam, which holds US$40 billion in reserves, is slashing its purchase of US treasuries and other Dollar-denominated bonds. Vietnam is seen as a weather vane for the bigger Asian powers. Together with China (US$1,340 billion), South Korea, Taiwan, Singapore and Thailand, they collectively hold US$3,775 billion in foreign reserves. Citing that the Dollar exposure is overheating the domestic economy and driving up inflation, Vietnam said that it would gradually move towards a floating currency. Analysts see this as a move of no confidence in the US economic management. Iran, expectedly, is talking about the possibility of its refusal to accept dollars for its dollar exports, preferring to be paid in a “more credible currency”. It will be of interest to note that hardly 15 per cent of Iran’s oil exports are denominated in the Dollar. It prefers to whittle down even this to avoid the excessive risk of devaluation.

Kuwait is more or less out of the Dollar loop. Bernanke’s actions matter very little to it. But others’ are not yet in the clear. It will be no surprise if the US Fed Reserve Chairman were to go for fresh interest rate cuts in the days to come. What is the prognosis for the US economy at this juncture? “It seems that the problems faced by US economy are more complex than ever before. The oil rich Arab world will probably continue to recycle petrodollars in the US treasury. But at some point they will also want to be compensated for a weaker dollar,” reasons Toronto-based Chief Investment Officer Zaigham Shah, whose FrontierAlt Inc has the GCC on its radar for parking funds.

So, if Bernanke were to sneeze next time, can the central bank honchos in Oman, Saudi Arabia, Bahrain, Qatar and UAE afford to turn a blind eye and go on their own path? It will be a tough call. For when all is said and done, we are talking about the world’s one and only superpower which does not believe in mavericks. Follow the leader or else.…

In 1986, it made a lot of economic sense for the Gulf economies to embrace the US Dollar parity. Today the situation is different. Conventional wisdom says, there are ‘horses for courses’. Hence, the decision to drop the Dollar peg – if it were to happen – will be more of a political, rather than an economic issue. Therefore, the royal heads of GCC will be the final arbiters in settling the Dollar dilemma once for all. So, who’s going to blink first? Let’s wait and watch.

Top^